In a simple sales transaction involving an item, a merchant has nearly complete ownership rights prior to selling the item to a customer. These ownership rights generally include the right to possess and use the item, the right to risk damaging or losing the item and the right to transfer ownership of the item to a third party. When the customer purchases the item, these rights are then transferred to the customer in exchange for the payment of money to the merchant, and the merchant has no further ownership-type interest in the item.
However, many transactions involving valuable items are not so simple, particularly when the customers are members of the general public rather than repeat business clients. In such transactions, the item cost in a simple sales transaction is so high that customers cannot easily pay the sums of money involved. Hence, merchants and customers are desirous of alternate types of transactions that allow customers to immediately enjoy some ownership rights, such as the right to possess and use, in exchange for immediate payment of less money.
Accordingly, installment sales and traditional financing are often used as alternate types of transactions. With such arrangements, the customer typically receives all ownership rights, except that a security interest is reserved for the merchant or entity providing financing. For convenience, no distinction is made below between a merchant and a financing entity or other middle man, and all such entities will be referred to individually and collectively as the merchant. Typically, the customer pays a small portion of the total price initially and periodic payments over time. The total sum paid over time is usually much greater than would have been paid in a simple sales transaction due in part to routine interest paid on the merchant's investment.
Unfortunately, a security interest in the item in combination with a mere routine interest payment does not adequately compensate the merchant. Consequently, merchants typically demand either a high interest rate or a high sales price, or both, in order to be adequately compensated.
One situation in which a security interest and routine pricing do not adequately compensate a merchant occurs when a customer declares bankruptcy. Typically, if a customer declares bankruptcy, the merchant becomes just another creditor in the pool all the customer's creditors. With this status, the merchant can expect to receive only pennies on the dollar for the merchant's investment, and that only after expending considerable administrative time and effort.
Another situation where a security interest and routine pricing do not adequately compensate a merchant occurs when the customer fails to honor its obligation to make future payments. Then, the merchant must either write-off the item or file a civil law suit, both of which increase a merchant's costs. Accordingly, pricing is typically increased to compensate for the merchant's increased risks of a customer declaring bankruptcy or otherwise failing to honor its future payment obligations.
Another alternative to a simple sales transaction is a lease, or lease-to-buy arrangement. In a pure lease, the customer makes periodic payments in exchange for the rights to possess and use the leased item for a period of time. However, the customer has no ability to obtain further ownership rights, such as the right to transfer the item to a third party. With certain types of items, such as non-depreciating items, customers view this alternative as being unacceptable because they cannot enjoy item appreciation. In other types of items, periodic payments are typically set sufficiently high to offset worst-case depreciation, and the customer often pays more than would be paid with other simple sales transaction alternatives.
In a lease-to-buy arrangement, a customer is often given an option to buy the leased item at a set residual price at the end of the lease term. The residual price is typically much less than the purchase price would be for a simple sales transaction, and is often a trivial amount, such as $1.00. However, such lease-to-buy arrangements are typically convertible into an installment sale should the customer declare bankruptcy. Consequently, the merchant must increase pricing to compensate for the increased risk of potential customer bankruptcy.
The above-discussed alternatives to a simple sales transaction pose a problem to the customer of having to pay undesirably high prices, all factors considered. Yet another problem for the customer with these alternatives is that they limit a customer's ability to either remove future payment obligations or exchange the item for another item that may better meet the customer's needs at some future date.